BIP - ClearBridge Canadian Dividend Strategy Q4 2023 Portfolio Manager Commentary

2024-01-20 07:20:00 ET

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• Canadian equities surged in the fourth quarter, as market attention pivoted from expectations of interest rate increases to the potential for rate cuts in 2024.
• Although the Strategy generated a strong absolute return in the quarter, it underperformed its broader Canadian equity benchmark largely due to impressive performance by non-dividend-paying information technology stocks.
• We remain mindful of the distinction between factors likely to have a lasting impact on businesses and those that can be transitory. While certain segments of the market seem susceptible to derating, we are uncovering more promising opportunities as market dislocations become more broad-based.

By Ryan Crowther, CFA, & Les E. Stelmach, CFA

Market Overview

The S&P/TSX Composite Total Return Index returned 8.1% in the fourth quarter. Benchmark 10-year interest rates in Canada and the U.S. reached 2023 highs of 4.24% and 4.99%, respectively, in October before ultimately giving way in the final two months of the year to close at 3.11% and 3.88%. Following a U.S. Federal Reserve meeting in December that highlighted easing inflation and slowing economic growth, rates priced in a more dovish consensus.

The advance in Canadian equities was broad-based, with information technology (IT, +24.0%), financials (+12.7%) and real estate (+10.7%) leading the charge. In addition, the defensive/non-cyclical sectors of utilities (+8.2%), consumer staples (+8.1%) and communication services (+7.6%) all performed well, while energy was the only sector to decline (-1.3%). IT capped off a strong year buoyed by investor enthusiasm for the possibilities of artificial intelligence ('AI'), and as lower interest rates eased pressure on valuations of equities with longer-duration projected cash flows. Weakness in energy was driven by lower commodity prices. Crude oil prices declined despite Middle East conflicts on inconsistent global demand indicators and sufficient supply, while natural gas price weakness reflected the generally warm winter conditions experienced to date this heating season.

Although the ClearBridge Canadian Dividend Strategy generated strong absolute returns in the quarter, it underperformed its broader Canadian equity benchmark largely due to impressive performance by non-dividend-paying IT stocks in the benchmark.

Portfolio Positioning

There were few wholesale changes in holdings in the fourth quarter. However, we took advantage of continued weakness in utilities early in the quarter to add to positions in Canadian Utilities, Fortis ( FTS ) and Brookfield Infrastructure Partners LP ( BIP ).

In the energy sector, Pembina Pipeline ( PBA ) consolidated its JV interest in the Alliance Pipeline and Aux Sable facilities during the quarter, acquiring the remainder of Alliance and an additional 42.7% of Aux Sable from Enbridge ( ENB ) for $3.1 billion. Pembina is a leading Canadian midstream and pipeline company, operating the largest network of gathering and processing, NGL pipelines, storage, fractionation and marketing assets in the Western Canadian Sedimentary Basin and connecting the Montney/Duvernay formations to end markets. The acquisition was funded in part through the issuance of subscription receipts, and the offering provided an opportunity for us to establish a new position in the company. Each subscription receipt entitles the holder to one common share of Pembina upon closing of the acquisition (expected in the first half of 2024). The integrated network creates a competitive advantage that would be costly to replicate. With assets located in the most productive plays, Pembina should be able to increase the utilization of existing assets, grow faster than the basin and profitably add capacity through smaller-capital, higher-return investments. More holistically, we viewed the offering as an attractive discount to intrinsic value for Pembina as a whole and as an effective way to start a position in a leading energy infrastructure company.

"We believe valuations of many equities are embedding uncomfortably high expectations for profitability in the year to come."

Late in the quarter, we added to our position in Intact Financial, a holding first added to the portfolio in the third quarter of 2023 when we participated in a well-subscribed secondary offering.

The only meaningful trimming in the portfolio was in our Brookfield Corporation ( BN ) position. With interest rates declining, we sought to capture some of the positive impact of higher values ascribed to the company’s asset management vehicle, Brookfield Asset Management ( BAM ), as well as its interests in drop-down limited partnerships Brookfield Renewable Partners ( BEP ) and Brookfield Infrastructure Partners ( BIP ).

Outlook

With 2023 investor sentiment seeming to have embraced more of a glass half full sentiment as we progressed through the year, we believe valuations of many equities are embedding uncomfortably high expectations profitability in the year to come. We believe that our bottom-up process and fundamental approach to valuation positions us well in this environment. We will continue to consistently adhere to our framework and to seek out opportunities for the portfolio as they present themselves. We remain mindful of the distinction between factors that are likely to have a lasting impact on businesses and those that can be transitory. While certain segments of the stock market seem susceptible to derating to us, we are uncovering more promising opportunities as market dislocations become more broad-based — particularly with sectors and securities that haven’t kept pace with the more favored parts of the market.

Although the portfolio emphasizes dividends, our approach remains oriented around risk-adjusted total return and not merely “income.” Valuation is the primary driver of our portfolio decision making, but embedded in our assessment of valuation are core attributes we seek, such as secular growth, profitability and durability of the business, quality managements with diligent approaches to capital allocation, and capital structures that align with the predictability of cash flows and cyclical exposures. We use this approach to design a portfolio with an attractive but not overly ambitious dividend yield, and one that seeks to optimize the risk-adjusted return potential of the Strategy.

Portfolio Highlights

The ClearBridge Canadian Dividend Strategy* underperformed its S&P/TSX Composite Total Return Index benchmark during the fourth quarter. On an absolute basis, the Strategy generated gains across eight of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors came from the financials and utilities sectors.

On a relative basis, overall sector allocation and security selection detracted from performance. In particular, underweight allocations to the IT and financials sectors as well as stock selection in the consumer staples, IT and communication services sectors weighed on results. On the positive side, selection in the materials and utilities sectors and an underweight to materials contributed to performance.

On an individual stock basis, the largest contributors to relative returns were from Open Text ( OTEX ), Agnico Eagle Mines ( AEM ), Canadian Utilities ( CDUAF ), TELUS ( TU ) and TMX Group ( TMXXF ). Holdings that detracted most from relative returns were Brookfield Corp., Manulife Financial ( MFC ), Topaz Energy ( TPZEF ), Tourmaline Oil ( TRMLF ), and ARC Resources ( AETUF ).

Ryan Crowther, CFA, Portfolio Manager

Les E. Stelmach, CFA, Portfolio Manager

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